QUESTION A3: EQUITY VALUATION (10%) The common stock of PQR Inc. is expected to

Question

QUESTION A3: EQUITY VALUATION (10%) The common stock of PQR Inc. is expected to pay a dividend of $15 for each share exactly one year from now. Given the risk of the stock, the market requires a rate of return of 22%. The dividends are expected to grow in perpetuity at a constant rate of 10%.

(iii): Prove using a forecast of future earnings, calculation of yearbyyear NPV of plowback, and the standard PV arguments that this PVGO is correct.

(iv): Work out how the firm’s P/E ratio will change if from t=0 onwards the firm chooses to retain 5% instead of the current 39.5%, in the business.

(v): Suppose appropriate discount rate for the firm’s stock rises to 30% (from 22% that we had earlier assumed). Explain qualitatively why the P/E does not rise when the firm increases the retention ratio.

Explanation / Answer

QUESTION A3: EQUITY VALUATION (10%) The common stock of PQR Inc. is expected to

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